Volatility and uncertainty in Europe persist. How sensitive are investors to the European situation? When the troubles of a nation that makes up only 0.2% of Eurozone output is blamed for downward movement of the U.S. stock market, that’s a sign of tremendous sensitivity. More on that country and why it has made investors skittish later, but first let’s look at current state of Europe and especially those nations that use the Euro currency (commonly called the Eurozone).

There are two interrelated issues we need to consider when evaluating the European situation: the state of the economy, as well as the severe financial pressure brought on by the enormous debt obligations of governments. This is the vicious circle that Eurozone countries find themselves in: there is a need to reduce government spending in order to improve the debt obligations, and this reduced spending weakens the economy. The weakened economy reduces tax receipts, and the reduced tax receipts make it more difficult to pay the debt obligations they were seeking to reduce. This not only keeps the debt obligations high, it also makes investors demand a higher interest rate on the debt, which makes it more difficult for the country to afford the payments. In the end, the real fear is that governments will default on their bonds and that these defaults will have a fatal effect on the banks that own the bonds. The banks going under would then have a domino effect and cause more and more banks to become insolvent. Because the consequence could be disastrous, even a small move toward that scenario has a large impact on investor confidence.

So, what is the current state of the Eurozone? The Eurozone as a whole has entered another recession after a short period of meager growth coming out of the global financial crisis. The combined economic output of the 17 countries that make up the Eurozone shrank by 0.6% in 2012 and is projected to lose another 0.3% this year. Unemployment has been steadily increasing and is now at an alarming 11.9%. In summary, the economy is not in great shape, but, to date, it is still your typical garden-variety recession—not a sign of Armageddon.

On a slightly better note, the debt side of the equation has been showing some improvement. The countries on the periphery that have been under the most stress are showing some improvement in their account deficits. In a normal situation, the financial condition of a country would have led to a weaker currency, thereby supporting export growth and foreign investment. But because these countries share a currency and such devaluation is not possible, other market forces must ultimately work. In this case, market forces have gradually reduced wages, making goods cheaper. Also, the European Central Bank’s pledge to support the Eurozone’s banks “at any cost” helped to lower the interest rates of government debt, enabling countries to better afford their debt payments and reducing investor concerns.

Even with the improvements, the immediate outlook remains challenging. Political turmoil reduces investor confidence. As we’ve seen, reduced confidence increases the interest rates that investors demand for a country’s debt. Italy, Greece and Spain abound in such political turmoil. Additionally, the record high unemployment in several countries further deteriorates their economies and sends them deeper into recession. Then there are events such as the one plaguing Cyprus, the aforementioned nation that makes up only 0.2% of Eurozone output. The Cypriote situation is one in which banks actually were fatally harmed by the defaults of Greek government debt. Cyprus was forced to close the country’s second-largest bank and inflict large losses to its biggest depositors. Because this was a visible step toward the disastrous outcome that investors have long feared, markets reacted. The real economic effects of the Cyprus situation are negligible, but the real damage was to investor confidence: “If it can happen there, who is next?”

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

While fourth quarter 2012 earnings results will continue to garner attention, investors may also be looking overseas to gauge market direction, especially with the recent, first meeting of the year for European finance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in Europe.

However, this year may be different. In 2012, the European Union finally took two important steps to halt the financial aspect of its ongoing crisis.
One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market. Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress.

With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, we do not expect market participants to fear a European financial crisis this spring and drive a 10% decline for U.S. stocks as they have in recent years. But Europe’s crisis is far from over, and market participants may drive stocks lower later this year.

Europe has traded a financial crisis for an economic one. The ECB is able and willing to only fight one crisis. The price Europe has paid to avoid a financial crisis is in the form of recession and unemployment rising above 10% — including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Inflation is still over the 2% target.

This is not just a shift in the crisis facing Europe’s southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment.

The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of financial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require financial aid. Germany, the de facto decision maker as a result of making up the lion’s share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis.
In early 2012, the European fear gauge was the bond yield of southern European countries rising as the financial crisis worsened. But now that a financial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European financial crisis has eased, Portugal’s 10-year bond yield fell from 16% last summer to 6% [Figure 2], and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germany’s 10-year bond yield fell below 1.5% [Figure 3]. This is not a sign of crisis averted, but of a different one brewing. Economists’ estimates for Germany’s gross domestic product (GDP) in 2013 are still coming down. Europe’s 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years.
The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europe’s evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the financial crisis was averted last summer, investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.

Europe is nearly through its August holiday and the only evidence of progress in the debt crisis has been press releases and sound bites from vacationing heads of state. Recently, however, the German weekly newsmagazine Der Spiegel reported that the European Central Bank (ECB) is once again debating a plan to cap interest rates in countries like Spain and Italy by buying unlimited amounts of their bonds.

The ECB, of course, immediately denied the report, as the plan’s potential to saddle German taxpayers with huge debt makes it a political non-starter for the EU’s most powerful member. Just to underline how Germany doesn’t (at least publically) approve, both the German Finance Ministry and the Bundesbank made it clear that any such plan is unacceptable, which didn’t stop the Spanish and Italian bond markets from rising on the news, thereby lowering interest rates.

Meanwhile, the Eurozone economy, as expected, contracted in the second quarter, with Germany positive, France flat, and most of the remaining countries negative. Less government spending, lack of hiring and worsening consumer sentiment led to a consensus estimate from economists of further contraction in the third quarter followed by weak growth in the fourth.

None of that is good news for the American economy or American investors. Europe as a whole is our largest trading partner, so slack demand across the Atlantic means lowered demand here, slower job growth, and lower profits for many American companies, particularly those with a large percentage of their business overseas. (Think Coca-Cola, Microsoft and General Motors, just to name a few.)

Compounding the problem is the continuing uncertainty as the Euro crisis drags on, month after month, with stalemate, and often economic impotence, built into the structure of the European Union itself. Don’t look for a resolution any time soon.

As always, the best defense is a diversified portfolio and the advice of a smart, experienced financial advisor.

The jump in volatility recently has caught the interest of many investors and prompted thoughtful questions about the economy. We have been tracking three primary subject areas on a daily basis through these unusual global financial events: (1) the health of the U.S. financial recovery; (2) the European debt crisis; and, to a lesser degree, (3) the health of China and other Asian economies. These first two issues are at the heart of the recent market volatility.

The European Union is in an unfortunate position of slow to declining growth combined with unmanageable levels of debt. In most economic downturns, the cycle to reverse the decline is a decrease in interest rates by the Central Bank, which puts more cash into the system and creates a declining currency value. As a result of low borrowing rates and attractive currency exchange rates, domestic and international spending slowly improves. The 17-member Euro zone does not have this luxury because, while they share a Central Bank lending rate and currency exchange rate, they pay their own sovereign debt at a borrowing rate set by the market. Countries that have very high levels of debt—like Greece, Spain, Ireland, Portugal and Italy—cannot muster the growth needed to raise revenue to pay their existing debt and cannot issue more debt at a cheap enough rate to make it financially viable for the long term. It is a vicious cycle that has been a decade in the making. While it seems to have been a slow-moving train wreck, we appear to be nearing the climax. Ultimately, that should be good news because it would create some clarity in an uncertain world. The hope is that the Euro zone will solve the current problems without an undue level of bank failures and defaulting loans, while also fixing the deficiencies in the system. There have finally been some meaningful ideas offered, such as a rescue fund that can borrow from the European Central Bank, thus ensuring enough resources to bail out even a large participant like Spain.

In addition to news from Europe, every day we see some chart that compares the current financial recovery in the United States to recoveries in the past. More often than not, the current recovery is shown to be very weak and fallible compared to others. A strong recovery creates jobs, increases our standard of living, and ultimately increases personal net worth. We want a strong recovery because we want all of the above, so it is disappointing when jobs growth or retail sales or home sales are reported to be unexpectedly weak. Although it has been frustratingly slow, and may continue to be for awhile, the good news is that our economy is making progress. The even better news is that when the rest of the world gets its act together, the United States seems poised for solid growth and a recovery. Recent earnings reports show a very lean corporate America with little fat to trim. A pickup in global sales should have a pronounced and immediate impact on the American economy.

The outcome of the European debt situation and the recovery path of the U.S. economic recovery will influence the financial models and the psyche of investors worldwide. While the volatility causes us to pay extra close attention to world events, our outlook for a slow and steady recovery in the United States has not changed. We have lived through many of these market “blips” over the past few years and will probably experience many more over time.